Foreign Exchange (FX) Market Basics

Foreign Exchange Market

• Functions as a global, decentralized, over-the-counter marketplace for currency trading.
• Determines exchange rates for currencies by including all aspects of buying, selling, and exchanging currencies at current or predetermined prices.

Bid and Offer Price

• Dealers normally provide a two-way price, stating what level they will buy at, for the base currency against the variable currency at a cheaper rate.
• The dealer also provides at what level they will sell the base currency against the variable currency at a more expensive rate.
• In foreign exchange, dealers quote both bid and offer prices.
• Bid Price: the price a dealer will purchase a currency.
• Offer/Ask Price: the price a dealer will sell a currency.

Spread

• Represents the difference between the bid and offer price or rate.
• The dealer's profit for taking the risk of quoting prices to other parties.

Spot Rate

• Represents the current exchange rate between any two currencies.
• A company requiring immediate foreign exchange engages in spot settlement, with a one- to two-day delay in final settlement.
• Transactions generally convert one currency to another.

The Value Date

• Spot transactions involve delivery two working days after the dealing date, allowing time for paperwork and cash transfers.

How Spot Rates are Quoted

• When comparing currency prices, the base currency is the unit that does not fluctuate in amount.
• For example, USD/JPY refers to the amount of yen equal to 1 US dollar.
• The currency code on the left is the base currency, always 1 of the base unit.

Quoted/ Counter/ Variable Currency

• The Quoted currency or price currency fluctuates.
• In USD/JPY, JPY is the variable currency and the number of units equal to 1 of the base currency varies by exchange rate.

Cross Rate

• Cross exchange rates express the relationship between two currencies different from one's base currency.
• Refers to the exchange between two currencies, given the values with respect to a third currency.

Long Position

• A surplus of purchases over sales of a given currency.
• Benefits from the strengthening of that currency.

Short Position

• The surplus of sales over purchases of a currency.
• Benefits from the weakening of that currency.

Square Position

• Neither long nor short where the sales and purchases are equal.

Types of Forex Derivatives

• Futures contract
• Forward contract
• Option contract
• SWAP contract

Forward Exchange Rate

• The exchange rate between currencies at some future date.
• Commonly used as a foreign exchange hedge.
• A company agrees to purchase a fixed amount of foreign currency on a specific date, and at a predetermined rate.
• Locks in the exchange rate for settlement at a future date.

Forward-Forwards

• A swap deal between two forward dates.
• For example, selling "X" dollars 1 month forward and buying them back 3 months forward.
• The swap period is the 2-month span between the 1-month and 3-month dates.

Non-Deliverable Forwards (NDF)

• Instead of settling outright amounts at maturity, parties agree to settle the change in value between the dealt forward rate and the spot rate two working days before maturity.

Advantages of NDF

• Reduces counterparty credit risk by limiting risk to the settlement amount.
• Does not involve the usual settlement risk of the whole principal amount.

Futures Contract

• Similar to a forward exchange contract, but trades on an exchange.
• Contracts have a standardized size, expiry date, and settlement rules.
• Participants include hedgers seeking to lock in a price to diminish the risk of a future price change.
• Speculators enter into trades seeking potential gains.

Example of a Futures Contract

• ABC Company ships product to a German customer in February and expects to receive a payment of 425,000 euros on June 12 and wishes to hedge the transaction using a futures contract.
• The standard contract size for the EUR/USD pairing is 100,000 euros, so ABC Co. sells four contracts to hedge its expected receipt of 425,000 euros.
• Since the nearest Friday following the expected receipt date of the euros is on June 15, ABC Co. enters into contracts having that expiry date, but is electing not to hedge 25,000 euros of the expected receipt.

Forward Contract

• Is an agreement to buy or sell an amount of currency at a pre-established price on a particular date in the future.
• Traded on an over-the-counter basis between two parties, unlike futures contracts.
• Forward contracts are not bought and sold on exchanges frequently.

Option Contract

• Gives the buyer the right, but not the obligation, to buy or sell an asset at a price prior to or on a specified date.

Call option

• Permits the buyer to buy the underlying currency at the strike price.

Put option

• Allows the buyer to sell the underlying currency at the strike price.

Option Contract Management

• Easier to manage than a forward exchange contract because a company can choose not to exercise its option to sell currency if a customer does not pay.
• Options are especially useful for those companies interested in bidding on contracts that will be paid in a foreign currency.
• If they do not win the bid, they can simply let the option expire, without any obligation to purchase currency.
• If they win the bid, then they have the option of taking advantage of the exchange rate that they locked in at the time they formulated the bid.

Listed Options

• Currency options traded on exchanges.
• The contract value, term, and strike price of a listed option is standardized, while these terms are customized for an over the counter option.
• Within an option agreement, the strike price states the exchange rate at which the underlying currency can be bought or sold.
• The notional contract amount is the amount of currency that can be bought or sold at the option of the buyer.
• The expiry date is the date when the contract will expire, if not previously exercised.
• An option agreement requires the payment of an up -front premium to purchase the option, SO not exercising the option means that the fee is lost.
• It may be fine if a gain from currency appreciation offsets the fee.

Time Options

• The disadvantage is the cost, given the wide bid/offer spread involved, particularly if the time period of the option is a long one.

SWAP contract

• An agreement between two counterparties to exchange financial instruments or cash flows or payments for a certain time.

Example of a SWAP Contract

• An American business that borrowed money from a US-based bank in USD wants to do business in the UK.
• It makes interest payments in USD.
• It generates revenues in GBP
• It Is exposed to risk arising from the fluctuation of the USD/GBP exchange rate.
• The company can use a USD/GBP currency swap to hedge against the risk and needs to find someone who is willing to take the other side of the swap.
• A UK business sells its products in the US.